sub-prime mortgage

There’s a useful Op-Ed in today’s New York Times that we should all take to heart. In “The Economy is Partying Like It’s 2008,” Desmond Lachman, a resident fellow at the American Enterprise Institute, a former deputy director in the International Monetary Fund’s policy development department and a former economic strategist at Salomon Smith Barney writes of the economic warning signs all over the economy right now.

Certainly, the American economy is doing well, and emerging economies are picking up steam. But global asset prices are once again rising rapidly above their underlying value — in other words, they are in a bubble.

Most importantly, according to Lachman, people who ought to know better are keeping mum over what should be the warning signs. Even worse, where ten or so years ago there was a bubble in real estate, today there are bubbles—plural—all over creation.

Stock values are at lofty heights that have been reached only three times in the last century. At the same time, housing bubbles are all too evident in countries like Australia, Britain, Canada and China, while interest rates have been driven down to unusually low levels for high-yield debt and emerging-market corporate debt.

So many bubbles bursting in close succession would make the job of putting everything back together a great challenge especially for an administration that doesn’t have the, uh, intellectual resources of the George W. Bush administration, which at least had Henry Paulson over at Treasury and a consensus for Keynesian economics. In 2008 everything went to hell in a hand basket when Lehman Brothers failed because it massively over invested in the sub-prime mortgage market.

Bitcoin or more generally cryptocurrencies might be the next Lehman Brothers in waiting. In 2008 Lehman had assets of $680 billion supported by only $22.5 billion of firm capital.

From an equity position, its risky commercial real estate holdings were three times greater than capital. In such a highly leveraged structure, a 3 to 5 percent decline in real estate values would wipeout all capital.

We face a similar situation with Bitcoin right now. I am not a finance guy and do not offer investment advice, so please don’t view this as anything more than bloggertry, to coin a phrase. But, hey, there’s about $300 billion in Bitcoin out there and more if you count the ICOs of similar instruments. Bitcoin are non-sovereign, they have nothing like the full faith and credit of the United States (or even Brazil) behind them, they are not regulated and there are no central banks waiting to provide liquidity in the event of a market hiccup.

On the contrary, they are dark holes into which real dollars are poured. It doesn’t help that exchanges and hedge funds are beginning to trade them and options on them. Recall that in the mid-2000’s exchanges and brokerages began trading in CDO’s, fancy options backed by mortgages that ranged from solid to sub-prime. When the sub-prime market wobbled, CDO’s and the brokerages supporting them became unsteady and Lehman failed bringing down the whole world financial system.

Yes, we got through it all but not without ruining lives and it took a decade of lackluster economic activity to get back to where we were before the crash. The problem as Lachman sees it is that,

Economic policymakers seem to have lulled themselves into a false sense of security by trusting the stricter bank regulations put in place after the collapse of Lehman Brothers in 2008. They seem to be turning a blind eye to the dominant role that so-called shadow banks (hedge funds, private equity funds, large money market funds and pension funds) play in the American financial system now.

Bitcoin’s trading is nearly all retail and in the shadow banking system where it can’t be regulated. Small investors are Bitcoin’s greatest entrepreneurs. It seems reasonable that, like Ebola emerging from the jungle, we could see a financial contagion emerging again from the shadows and Bitcoin appears to be a vector.

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